Attack on Income Splitting

On July 18, 2017 the Minister of Finance (Finance) announced sweeping changes to limit the tax planning that has been the cornerstone of Canadian-controlled private corporations and their shareholders. While the changes announced covered several areas, this document focuses on proposals related to income splitting (excluding multiplication of the capital gains exemption, which will be dealt with in a follow-up document). Draft legislation was also released with the income splitting proposals. The draft legislation is subject to a commentary period ending October 2, 2017, with the intention that it is effective January 1, 2018.

It is tempting to criticize the proposals released by Finance, however, at this time, it is better to describe where we will potentially end up.

Introduction

Finance introduced the income sprinkling1 “problem” as follows:
► Income sprinkling describes a range of tax-planning arrangements that result in income that, in the absence of the particular arrangement, would have been taxed as income of a high-income individual, but is instead being taxed as income of another lower-income individual, typically a family member of the
high-income individual. The effect of the arrangement can be to have income subject to a lower effective income tax rate. This is achieved by accessing tax attributes of the lower-income individual, including the individual’s lower marginal tax rates, personal tax credits (such as the basic personal amount) and,

► Income sprinkling arrangements are possible because the private ownership of a business permits its principals to more easily control or influence the legal form of the ownership of the business and the circumstances in which profits are distributed. Specifically, the principals of private businesses can arrange for distributions to be made (typically by way of dividend payments in the case of a corporation) to other individuals (typically family members) in a way that minimizes the overall amount of personal income tax paid on that income. The income distributed to the family member may exceed what would have been expected, having regard to the family member’s labour and capital contributions to the business, in arrangements involving arm’s-length investors.

 1 The tax community uses “income splitting”. Finance decided to call it “income sprinkling”. Pension income splitting is not subject to the changes described.

1999 Kiddie Tax

Notwithstanding the above concerns, income splitting with minors was already prevalent in the mid-1990s. As an example, a family trust would hold shares of a private corporation earning business income. The corporation would pay a dividend to the family trust which in turn would designate the dividend to a minor. The minor’s guardian would file a personal tax return on behalf of the minor in respect of the dividend received, and depending on the magnitude of the dividend, very little tax would be paid.

Effective with the 1999 taxation year, Finance introduced legislation to curtail this type of planning. A special tax on income split with minors (“tax on split income” or “TOSI” or “kiddie tax”) was introduced to address splitting of certain income with minor children. The so-called kiddie tax rules apply to income from private corporation arrangements, such as dividends, or income in the form of a trust or partnership distribution derived from a business or rental activity of a related individual. Where the kiddie tax applies, the income “remains” with the minor, but is subject to the top marginal tax rate (instead of marginal tax rates), and personal tax credits (with the exception of the dividend tax credit and the foreign tax credit) are denied. 

The kiddie tax effectively taxes the income as if the business owner/principal had received the income. 

Planning Example

Notwithstanding the introduction of the kiddie tax, tax planning involving private corporations and their shareholders was still undertaken to capitalize on the ability of young adults to receive dividend income from a related private corporation. Very little tax would be paid by the young adult given, for example, tuition credits as a result of attending university, or less tax would be paid given access to low marginal tax rates. The young adult’s ownership of the private corporation shares would be structured through a family trust in many cases. A secondary benefit of such a structure was that to the extent the said private corporation was sold, a capital gain might be realized by the family trust (to the extent shares were sold), with such gain being designated to the young adult and potentially being sheltered by his or her capital gains exemption.

The planning in question could also have utilized a partnership or a trust for income splitting purposes.

Proposed Measures

The kiddie tax rules are proposed to be extended to certain adult individuals who receive income from a business of a related individual, including a corporation over which a related individual has influence, to the extent such income is regarded as unreasonable in the circumstances.

The terminology used by Finance in describing the application of the kiddie tax rules to the affected adult individual is as follows: “...these measures would apply the TOSI to a Canadian resident adult individual who received split income...when the amount in question is unreasonable under the circumstances. An adult individual in receipt of split income would be liable for the TOSI on the unreasonable portion of the income.” As referenced above, “TOSI” is a reference to tax on split income – like kiddie tax, but now it applies to adults. 

Key Concepts

First, there needs to be a “specified individual”. This is the individual that receives the income to which the TOSI potentially applies. While there are several criteria to the definition of specified individual (who is not a minor), the key is that the individual receives income or realizes a capital gain from or related to a business, and that business is carried on by a related individual. The business in question could be carried on by the related individual directly or through a corporation, partnership or trust, that the related individual is involved with.

In the above example involving the young adult, the young adult would be a "specified individual".

It is possible, but not clear, that the reference above to “business” also includes the investing of an investment portfolio (for example, an investment holding
corporation).

Second, the concept of reasonableness is introduced. In order for the TOSI to apply to the specified individual, the income (or correctly put, the split income) must be considered to be unreasonable in the circumstances. Again, in the words of Finance: “If a split income amount received by an adult specified individual is reasonable within the meaning of this test, then the amount that would otherwise be split income of the individual would be excluded from split income and thus not be subject to the TOSI.”

The factors that will be used to assess if an amount received by a specified individual is reasonable are as follows:
• The functions relating to the business performed by the individual to the extent that the individual – before the amounts were paid or became payable – is
engaged in the activities of the business (i.e.: labour).
• The assets contributed, directly or indirectly, by the individual in support of the business (ie: capital).
• The risks assumed by the individual in respect of the business.
• The total of all amounts already paid to the individual before the end of the year.

It should be noted that the above factors in respect of labour and capital are modified depending on whether the individual is between the ages of 18 and 24, or age 25 and older. The factors are more restrictive for the 18 to 24 age group.

Finance’s desire to address income splitting based on what is reasonable will result in a significant amount of uncertainty in this area. This is acknowledged by Finance in its introduction to the proposals as follows:
► The Government is seeking input on whether the reasonableness test provides an appropriate mechanism for responding to income sprinkling.The Government recognizes that the proposed reasonableness test depends on the facts of each case, and questions concerning the measurement of contributed value, or the evidence required to support such contributions, will not always be straightforward.

What About Capital Gains?

As mentioned above, capital gains realized by a specified individual may also be regarded as split income and subject to TOSI. Also, these proposals will likely decrease the usefulness of estate freezes (where parents transfer the future growth in value of a business to the next generation).

Another Example

The income splitting proposals may adversely impact the following simple situation: Joe and Susan are married. Joe is a software development expert and
decides to start his own company. Susan does not currently work as she is studying to become a doctor. On incorporation of the company, Joe and Susan become equal shareholders of the company. This is done so that Joe and Susan can income split by having the company pay dividends to Joe and Susan. This is attractive as Susan does not have any other sources of income and some taxsavings will be achieved.

In the first few years of the company, things are slow. However, after a few years, the company becomes profitable and after-tax profits are paid out to Joe and Susan in the form of dividends. The income splitting is working as Susan is still in school.

Later, Joe receives an offer for the company that he and Susan can not refuse. The shares are sold and Joe and Susan each realize a capital gain.

Is the dividend income that Susan received over the years reasonable (in light of the criteria summarized above)? The income splitting proposals, in this case, will likely subject Susan to TOSI in respect of the dividends. Susan will pay tax at the highest marginal tax rate on those dividends, notwithstanding that Joe, who otherwise could have received the dividends, may not be subject to the highest marginal tax rate.

Is the capital gain realized by Susan reasonable? It also will likely be subject to TOSI (because the dividends were).

What’s Next?

There will likely be a significant amount of feedback provided to Finance by the October 2, 2017 deadline. It is difficult to predict what changes, if any, Finance will make. Regardless, some form of legislative change will be forthcoming. It will be important for individuals and their private corporations to stay informed and perhaps increase the level of communication with their advisors.

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